Myths and Facts About Corporate Taxes, Part 3: Are American Companies’ Profits Trapped Overseas?

After dispelling some unwise conventional wisdom about corporate taxes (first that American corporations pay the highest tax rates in the developed world, and then that “tax reform,” as commonly defined by Congress and businesses alike, would be either sound policy or good politics or both), here’s another tired idea that needs to be put to bed: Taxing American multinationals’ overseas profits when they return home “traps” money overseas and is a leading cause of the American corporate code’s “anti-competitiveness.”

The U.S. corporate tax code is unlike many other developed nations’ in that it taxes its multinationals’ profits that are earned overseas. (Taxing profits no matter where they’re made is called a “worldwide” tax system.) However, American corporations may defer payment on these taxes until they bring their overseas profits back to the States in the form of dividends. American corporations are well-versed in ways to use this cash overseas (for example, if classified as “permanently reinvested” in a foreign country, those earnings are exempt from U.S. taxation), and thus avoiding “repatriating” profits and paying taxes owed.

Corporations, and those they’ve managed to bamboozle on this issue, often say that these profits are “trapped” overseas. “Being obligated to pay taxes” is not the same as “trapped.” Imagine that your employer told you he’d love to pay you, but your salary is “trapped” because if you were paid then your employer would be obligated to remit payroll taxes to the Treasury. You would be rightfully skeptical of this “trapped salary” argument. However, corporations routinely trot out this “trapped” line to call for a “repatriation holiday,” during which profits earned in a foreign country could be brought to the United States at a reduced tax rate. (The previous such holiday was granted as a “one-time” deal in 2004, but corporations’ belief that it will be repeated is part of why their overseas cash hoard has grown so large—now up to $2.1 trillion.) Moreover, the anticipated benefits of the one-time tax holiday—increased business investment and hiring here at home—did not materialize; the 15 companies that repatriated the most foreign earnings cut more than 20,000 jobs over the following three years and “slightly decreased the pace of their spending on research and development.” The tax break also cost the U.S. Treasury $3.3 billion in lost revenue.

What American multinationals really want, however, is to ditch the taxation of overseas profits entirely. Called a “territorial” tax system—which many other nations employ—taxing only profits earned in the United States would result in the Treasury losing enormous amounts of revenue. A transition would cost $130 billion over 10 years, and serve as a subsidy to industries and firms that do a lot of business overseas.

Critics of our international tax system tend to argue that U.S. firms are at a disadvantage because they have to pay U.S. taxes on profits made in foreign countries, but their foreign competitors do not have to pay taxes in their home countries on profits made in the United States. Moreover, critics argue, countries such as Japan and the U.K. have made the switch from worldwide to territorial tax systems.

However, what American multinationals actually pay in taxes belies these concerns. First, American companies get a credit for the foreign taxes they pay on foreign profits; the tax they pay on repatriated income represents the difference between the foreign tax rate and the U.S. rate. Moreover, the Government Accountability Office found that large, profitable American multinationals pay just more than 17 percent in taxes worldwide. And both Japan and the U.K. included provisions in their new tax systems that brought them far from what U.S.-based multinationals are calling for, which former Joint Committee on Taxation chief of staff Ed Kleinbard has deemed “a cartoon version of the territorial tax policies followed by other nations.” (Japan, for instance, taxes foreign income if it is earned in a country with a tax rate lower than 20 percent.) Further, the U.K. may not be an apt comparison, as it was backed into making the transition to a territorial tax system because of European Union rules that prevent member countries from enacting anti-inversion provisions.

A better course would be to eliminate deferral and levy the tax on American companies’ overseas profits when they are earned, not when they are brought back to our shores. This would raise $600 billion over 10 years, and do much to increase tax fairness across industries and among firms. Indeed, this would be such a large revenue-raiser that some of the profits could be given back through rate cuts, thereby partially offsetting the huge increase in effective tax rates that would be borne by firms with large foreign profits.

In the long term, neither a worldwide nor a territorial tax system, narrowly defined, makes much sense in our truly global economy. If a company is based in one country, holds patents in another, sources material from four different countries, assembles its product in another, and sells it in yet another, to which should it pay taxes? The OECD is just starting to look at these issues, and one can hope that a broad, international agreement on global taxation will one day ensue.

But until then, don’t believe it when companies complain that our international tax system is anti-competitive, or traps money overseas that could and should be invested here. It’s just not true.